Fed's New Strategy To Combat Inflation - Let Banks Open CD Accounts At The Fed

WASHINGTON — The Federal Reserve on Monday proposed allowing banks to set up the equivalent of certificates of deposit at the central bank, a move that would help the Fed mop up money pumped into the economy and prevent inflation from taking off later.

Under the proposal, the Fed would offer so-called "term deposits" that would pay interest. Doing so would provide banks with another incentive to park their money at the Fed, rather than having it flow back into the economy.

The proposal comes as no surprise. Federal Reserve Chairman Ben Bernanke and other Fed officials have repeatedly said the creation of so-called "term deposits" – essentially the equivalent of CDs for banks – would be one of several tools the Fed could use to drain money from the economy when the time is right.

Against that backdrop, the Fed said the proposal "has no implications for monetary policy decisions in the near term."

With both the economy and the financial system on the mend, the Fed this year started to wind down and scale back some emergency lending programs. Many of those programs were set up at the height of the financial crisis in the fall of 2008 when some credit markets virtually shut down. Lending conditions have improved but still aren't back to normal. They continue to restrain the economic recovery.

The Fed's balance sheet has ballooned to $2.2 trillion, reflecting the creation of lending programs intended to ease the financial crisis. That's more than double the pre-crisis level. The Fed will need to mop up that money or it could trigger inflation down the road.

The Fed proposed that the interest rate paid on the term deposit be set through an auction mechanism.

Banks wanting to hold a term deposit would bid in regularly scheduled competitive auctions. The banks would indicate both the interest rate at which they are willing to be paid and the amount of money they want to deposit into the account at that interest rate.

Given that process, it's unclear now what the rates on the accounts would be.

The Fed said it anticipated term deposits with "relatively short maturities" likely ranging between one and six months. It said deposit maturities wouldn't exceed one year, and no early withdrawals of money in the accounts would be allowed.

The public, the banking industry and other interested parties will be given an opportunity to weigh in on the proposal. The plan could be revised before a final rule is adopted.

Most economists don't believe the Fed will start raising its key bank lending rate, which also influences a range of consumer lending rates, until the middle of next year.

At its meeting earlier this month, the Fed kept rates at record low and pledged to hold them there for an "extended period" to foster the recovery.

Separately, in a weekly report issued Monday, the Fed said banks cut back on emergency loans from the central bank, a fresh sign credit problems have eased.

The Fed said banks averaged $18.7 billion in daily borrowing over the week ending Dec. 23. That was a decrease of $344 million from the prior week.

Banks also drew fewer short-term loans – just $75.9 billion – from another Fed program called the term auction credit facility. That marked a decrease of $9.9 billion from the previous week.